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Tuesday, November 23, 2010

QE II and the recovery story: Is it time for austerity?

(The article was adjudged the best entry at Consilium – The Policy Design Competition at IIM Lucknow)

Quantitative Easing II better known as QE II has been globally the most discussed phenomenon in the recent times. Through this mechanism the US Federal Reserve will buyback 600 bn US$ worth of bonds, at about 75 bn US$ a month, and infuse newly created money in the system. The buyback follows the QE I that saw an infusion of 2 trn US$.

The step can lead to lowering of interest rates or yields in the US thus incentivizing investors to look for greener pastures abroad that provided greater returns. Considering the deflationary concerns in the US and the unusually high unemployment rate, “doing nothing” was not an option for the regulators. With Chinese not allowing Yuan to appreciate to the levels acceptable to the US, Fed through QE has taken it upon itself to undo the “trade imbalance”. QE through lowering of interest rates aims at spurring demand as well as consumption. This will generate jobs as well as lead to appreciation of asset prices which have touched new lows thus leading to foreclosures and defaults. As far as global economy is concerned, even they can benefit through FII inflows.

But QE has its share of concerns as well. Inflation can easily spiral out of control and lead to asset bubble if it works “too well”. A country recovering from a bout of recession can hardly afford consumption to be curtailed by the general public. The worst global impact could be a “currency war” with “competitive devaluation” by counties looking to boost exports. It could also lead to excessive inflows destabilising stock markets of emerging market as extra liquidity resulting from QE II will chase profitable havens.

But has the time for austerity arrived yet? With UK embracing austerity and deficit economies like Ireland and Spain too treading similar paths, countries around the world are losing their sleep over this topic. As far as India is concerned, RBI has raised the interest rates six times this year. It was expected considering inflationary concerns especially due to poor monsoon as well as liquidity crunch due to auctions. But the central bank is likely to refrain from further hike as recovery is still not complete. The recent IIP has disappointed and low metal prices may signal low demand. The realty sector has taken a beating as recovery eludes them. With not much help from the export front as protectionism is in the air, the country can hardly afford to suppress domestic consumption through austerity. In fact devalued dollar can help India lower its import bills and thus fuel investments in the country. So India should practice austerity only where wasteful expenditure is taking place else it could hamper not just the recovery but the growth story which is likely to pull Indians out of poverty.

As far as US is concerned, the government policies are going to play an important role in ensuring whether the recovery is full fledged or U shaped in nature. It won’t be prudent to rely solely on QE II which anyway is going to spread over a period of eight months and thus can be pulled back if it doesn’t work or achieves an early success. This is because the challenge lies in improving the sentiments to spur consumption or investments. Simply lower rates and huge liquidity won’t serve purpose if avenues and required returns can’t be foreseen.